Friday, November 21, 2008

Why should companies pay out dividends?

In theory it makes sense for companies to reinvest all of their earnings straight back into the business, compounding the growth rate of the enterprise to achieve a higher asset base. If a company can put their earnings to good use, there is no reason for them to pay fat dividends.In reality however the money is wasted away on failed acquisitions, taking on too much risk with new products. Companies that consistently not only pay but increase their dividends over time are more fiscally responsible than the companies that don't pay any dividends.

Companies that reward shareholders with dividends are showing confidence in their ability to generate growing earnings because they could afford to. Furthermore companies paying out dividends show shareholders those earnings are real and not manufactured by an army of CPA's.As a small business owner myself, I enjoy getting cash back from my businesses on a regular schedule so that I could decide if I wanted to reinvest into the business by purchasing more shares or spend it on something else.

Last but not least most companies can only grow their ROE/ROA so much as they could be reaching the limits of their marketplace. The ROE would then incrementally start declining, making it worthwhile for these stocks to pay out dividends instead of spending the cash on acquisitions to buy competitors or start a division in a completely new sector in order to diversify. More often than not branching out into different industries does not work.

Microsoft has been a recent stock which has initiated and closely followed a dividend growth strategy over the past five years. Cisco Systems also recently announced that it was seriously considering paying a dividend to its stockholders.

According to Ned Davis Research, dividend paying stocks have also outperformed non dividend paying stocks over the past 35 years.

To summarize it is nice for companies to pay out some portion of earnings (up to mid 50%) back and then reinvest the rest in the business. Long term success comes from good balancing of the owners’, management and enterprise interests.

4 comments:

Not to mention the fact that if companies didn't pay out dividends then the stock market as we know it could not exist. All the value of a share of stock is is the present value of all (expected) cash flows associated with owning that stock. Any capital gain/loss on a stock is just investors adjusting their present value of future cash flows (increasing or decreasing their expectations).

Even for companies that don't pay dividends (like RIM or Google), it is EXPECTED that they will pay them one day in the future; that's what the value of their stocks represent.

If no company ever paid out dividends and the expectation was that none of them ever will then the value of your shares in that company would be zero; there would be no future benefit to you of owning the stock.

So, the reason that people bought Berkshire all these years was the expectation that it would eventually pay a dividend? This, in spite of the fact that Buffett himself has said that he likely won't ever pay one?

I don't think that dividends (future or present) are a prerequisite for stock values. So long as companies use the capital sufficiently well, why wouldn't you continue to expect that, and continue to expect other investors to be willing to purchase that stock from you at some future time?

I would like to get increasing capital gains and I am all for some reinvesting of earnings back for the business to grow and maintain liquidity. But more often than not businesses spend those money on acquisitions/projects that not only do not add value but also lose a lot of funds. I am all for a balance. The issue in corporate US is that the shareholders are the last ones to get paid. That's why they should demand dividends from mgmt ( oh yeah executives still get paid with shareholders money even if the company is losing billions). A company that doesn't pay dividends shows that they do not believe in the stability of their business model.

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